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Raising capital is a pivotal moment for startups, often setting the trajectory for their growth and success.
When selecting startup financing, founders have many choices, each with distinct advantages and implications. This article focuses on one of those choices – whether to finance their startups with convertible instruments or priced equity rounds.
Extending Runway to Achieve Product-Market Fit
Seed rounds and “friends and family” rounds are often the first sources of external financing that a startup encounters. While crucial for getting projects off the ground, these rounds may not provide all the necessary capital to reach product-market fit.
Convertible instruments and priced equity rounds offer a bridge to further development and growth. These financing mechanisms are for raising capital and strategically managing resources to achieve key business milestones – most notably, product-market fit.
Product-market fit is the holy grail for startups, indicating that they've developed a product that meets market demand and is capable of sustainable growth. Achieving this fit is crucial, but it requires time, experimentation, and, crucially, capital. Convertible instruments and priced rounds provide this much-needed capital, extending the startup's runway.
The Appeal of Convertible Instruments
Early-stage companies especially favor Convertible instruments like convertible notes and SAFEs (Simple Agreement for Future Equity). A convertible note is essentially a loan that converts into equity at a later financing round, typically at a discount to the next round's investors as a reward for early backers. These flexible and efficient financial instruments allow companies to raise capital without setting a fixed valuation upfront.
The concept of "debt" is intrinsic to understanding convertible notes. As a form of debt, convertible notes are a financial obligation the company must eventually fulfill, either by repaying the debt or converting it into equity.
The SAFE, introduced by Y Combinator, streamlines early-stage financing even further. By eliminating interest rates and maturity dates, SAFEs reduce the costs and complexities associated with convertible notes, offering a more founder-friendly approach to securing early investments.
Convertible Note vs. SAFE
Choosing between a convertible note round and a SAFE (Simple Agreement for Future Equity) depends on the specific needs, preferences, and contexts of the startup and its investors. While both instruments are designed to delay valuation discussions until a later financing round, there are distinct scenarios where one might be preferred over the other.
Convertible notes accrue interest over time, which can be advantageous for investors as it increases the amount of equity they receive upon conversion. Convertible notes also come with a maturity date, by which the loan must either be repaid or converted into equity. These features may help set a timeline for the next funding round while making an investment more appealing to investors looking for a better return or an additional layer of security.
SAFEs are simpler and offer more flexibility for both parties. SAFEs are not debt instruments; they don’t have maturity dates or accrue interest, which simplifies the calculations for future equity conversion. SAFEs also typically have fewer terms to negotiate, which can streamline the investment process.
Since SAFEs convert into equity at future financing events, they align investor interests with those of the company, focusing on growth and value creation rather than debt repayment. Investors using SAFEs are betting on the company's future success, knowing that their return will come from equity obtained in a later priced round, potentially at a significant valuation increase.
Greater Transparency with a Priced Round
In contrast, Priced Rounds involve selling a portion of the company's equity based on a specific valuation. This method is more transparent regarding equity distribution and valuation but requires a consensus on the company's worth, which can be challenging for startups without a clear financial track record.
A notable instance of a priced round is ByteDance, the parent company of TikTok, which conducted a priced equity Series F round in 2018 that valued the company at $75 billion. This round was a testament to the company's massive growth and its potential in the global market, attracting major investors.
When you look at the concept of a priced round, you might think (correctly) that certain valuations may impose incredible risk for investors, based on company performance or underperformance based on projections. There are multiple ways that investors can protect themselves.
First, you’ll often see rights offerings built in, where investors have opportunities to acquire more shares and have a greater influence on how the business runs. Also common are provisions for acquiring preferred stock, which gives shareholders higher legal control over assets and profits. Some types of preferred stock enable the holder to participate in actual profit sharing, while others do not. Preferred stockholders may also receive protections in the form of liquidation preferences, where they are entitled to proceeds from liquidated assets of the company ahead of other shareholders and debtholders.
A final protection will be a subsequent down round, which we will discuss in greater detail in the next installment of this series.
Trends in Funding Rounds
The landscape of startup financing is diverse, with trends shifting over time based on economic conditions, investor sentiment, and technological advancements. SAFEs represented 80 percent of the capital invested at the pre-seed stage in the second quarter of 2023. But industries like medical devices, hardware, and biotech continue to attract substantial investments through convertible notes.
Regarding priced rounds in Series A, the average funding in 2023 through the third quarter was $20.5 million. This average is consistent with the past few years, but the total number of deals declined significantly since 2021.
The choice between convertibles and priced rounds often hinges on the startup's stage, valuation clarity, and the strategic goals of founders and investors. While early-stage companies may lean towards convertibles for their flexibility and lower upfront costs, more mature startups might opt for priced rounds to solidify their valuation and attract institutional investors.
